Can The Fed Really Stop Soon?

Economists didn't needed anymore data that showed the economy slowed during
the last part of the first quarter, but there was plenty that was released
over the past week that helped reinforce that opinion. GDP growth was lower
than expected for the first quarter of 2005 and slowed from the fourth quarter
of 2004. Consumer confidence fell in April according the survey from the University
of Michigan. Finally, both ISM surveys fell from the previous month. While
it is clear the economy has slowed, the relevant question becomes how significant
is the slowdown and will it led the Federal Reserve to stop raising interest
rates sooner rather than later.

We discussed on several occasions that the economic indicators would point
to lower economic growth. We also pointed out that this slowdown would not
be indicative of a weakening economy, but the natural progression of an economic
recovery. Last week, the Bureau of Economic Analysis reported that the economy
expanded by 3.6% on a year-over-year basis. While it is the slowest growth
since the third quarter of 2003, it should be remembered that the economy grew
by 5.0% during the first quarter of 2004. This was the highest year-over-year
growth in over ten years. The economy has expanded by 8.8% since the first
quarter of 2003. This two-year growth rate is the fastest pace since June 2000.
It is also faster than all but six periods during the 1990s. And that is on
a real basis. Using current dollars the economy has expanded by 13.4% over
the past two years. Amazingly, only the June 1998 to June 200 growth rate exceeded
this rate going back to 1990 when inflation was much higher than currently.

As previously mentioned, real GDP was weaker than expected, but the nominal
GDP was higher than economists expected. The GDP deflator rose to 3.2, significantly
higher than the 2.1% economists expected, which reduced the nominal GDP growth
rate of 6.3% to a real GDP growth rate of 3.1%. Economists were worried about
the $82.4 billion increase in inventories. Economists point out that building
inventories means that merchandise is building up because end demand has eased.
Plus the build up of inventories causes orders to decline as inventories are
whittled down. While the $82.4 billion increase in inventories is the highest
since June of 2000, there are several other reasons that could also explain
the increase in inventories. Raw materials prices have been steadily rising
for the past year. This has caused companies to stock up on raw materials hoping
to avoid higher future prices. Plus, the strained transportation system has
caused havoc for those utilizing just-in-time inventory management forcing
companies to maintain higher levels of inventory to avoid shortages.

Both the manufacturing and non-manufacturing ISM surveys showed purchasing
managers were less optimistic in April. The manufacturing survey dropped two
points to 53.3, the lowest since July 2003. Only the production and export
orders components rose. The most notable declines were in new orders and employment.
New orders dropped 3.4 points to 53.7, lowest since May 2003, and employment
fell one point to 52.3, which is the lowest it has been in sixteen months.
The non-manufacturing ISM dropped 1.4 points to 61.7. Similar to the manufacturing
survey, most components dropped, highlighted by new orders falling 3.3 points
to 58.8, lowest since June 2003.

April was a big month for auto sales, except for General Motors and Ford.
Overall industry sales came in at a 17.5 million unit rate. The Asian automakers
outpaced the rest of the industry by a huge margin. Overall the Asian producers
increased sales by 20.1% led by Toyota (up 25.9%), Nissan (up 31.9%), and Honda
(up18.0%). The Asian automakers grabbed 37.5% of the market in April, the highest
share it has ever garnered.

Overall, sales of the domestic nameplates fell 0.3%. Chrysler was the lone
gainer with sales up 9.3% compared to GM's 4.1% decline and Ford's 1.4% slump.
General Motors's results were actually worse than its monthly sales suggest.
Its retail sales were actually down 13% and its light truck sales fell 17.2%.
Sales of European brands were the weakest falling 9.1% in aggregate compared.
Volkswagen sales fell 28.1% and BWM sales were off 10%.

There are some indications that the economy continued to trudge along. Companies
continue to beat analysts' estimates for first quarter earnings. With 421 of
the S&P 500 having reported first quarter earnings, 284 (67.5%) have beat
estimates with only 19.7% missing. In aggregate earnings are up 14.1% compared
to last year. Challenger job cuts fell to 57,871 from 86,396 in March. This
was the fewest number of job cut announcements since November 2000. Over the
past six months job cuts have averaged over 100,000. The Bureau of Labor Statistics
will release the employment report for April on Friday.

While a significant portion of economic growth is due to inflation, the economy
is expanding faster than to justify the current level of interest rates. It
is also likely that inflation will continue to work through to consumers. Companies
have been able to withstand higher raw material and other input costs over
the past year because of contractual pricing and hedging practices that mitigate
the immediate effects of rising prices. Prices started moving up about a year
ago and now contractual prices have been renewed at higher prices and the cost
of hedging has increased.

Higher inflation should also cause the Federal Reserve to be more diligent
in achieving an equilibrium level of interest rates. After this week increase
in the federal funds rate, it raised to the lowest level reached during the
early 1990's recession. While current economic conditions dictate that rates
have a long way to go before reaching an equilibrium state, the nature of the
current economy makes it difficult to boost rates. The problem with higher
interest rates is that US has morphed into a financial based economy and this
level of interest rates would certainly play havoc on economic system. Unfortunately,
until then its likely that the economy will likely have dramatic ebbs and flows
with "hot sectors" experiencing a flood of activity, while other areas of the
economy barely tread water. The weaker economic data has allowed investors
to postulate that the Fed can stop raising rates after just a few more rate
hikes. Any indication that economic activity has picked back up will likely
cause long-term interest rates back up.